The Policy and Making of Smart Contracts in English Law

It is often taken for granted the fact that law and policy are inextricably intertwined. A general member of the public would more or less identify policy as the pattern of reasoning behind a government or organisation’s actions. Yet what we often forget is that the implementation of a certain law is also a stellar example of policy. This is especially the case in England, where previous court rulings, known as “Common Law” serve as integral precedents to every legal judgement in the country (primarily because English law has no formal codification). In this article, the President of the Law Policy Centre at King’s Think Tank has chosen to explore “The Policy and Making of Smart Contracts in English Law”, specifically in relation to “Exclusion Clauses”.

Ever since L’Estrange v Graucob in which the notable Mr Denning persuaded the Court of Appeal that provided the terms of an exclusion clause were clear enough, any liability for breach of contract can be excluded, there has been much pressure to outlaw unreasonable terms of exclusion if they are contained as part of a contractor’s standard terms of business.

Indeed, L’Estrange v Graucob continues to be a primary illustration and analytical starting point of contractual “exclusion clauses”. Much of the modern law and economic literature that examine exclusion clauses use this bargaining scenario or “game.” This scenario usually focuses on a consumer protection issue whereby one powerful contracting party forces a standard-form contract upon another much weaker contracting party. And, because the economics of exclusion clauses are often examined in such scenarios, bargaining is made almost impossible making the use of these clauses as bargaining tools a frequently a neglected topic. Instead, significant research and attention are directed towards the use of exclusion clauses as an allocation of risk.

This risk-analysis approach is generally correct. In some cases it may even identify instances where consumers take on too much risk. However, its limits are that it may only explain the effects of an exclusion clause in economic terms. It does not examine how exclusion clauses can be used as consideration in contractual bargaining. The failure to do so is understandable, since in the classic scenario of parties with unequal bargaining powers there is no question of how or why the more powerful party insists on using an exclusion clause. Instead, there is usually no bargaining over the inclusion of the term in the contract and the term becomes either ineffective or is invalidated by either Unfair Contract Terms Act or the Consumer Rights Act.

Thus, it is only until an exclusion clause is disputed between parties of equal strength (as in African Export-Import Bank), that the use of exclusion clauses as bargaining tools becomes relevant. Instances whereby exclusion clauses are being used in arms-length negotiations are only increasing, boosting the relevance of the study of exclusion clauses as an economic bargaining tool.

There are two main ways in which exclusion clauses affect bargaining. Firstly, an exclusion clause is an instrument of risk, as explored in previous literature. An exclusion clause may be used to transfer and hedge risks. Thus, in a perfect bargaining environment, an exclusion clause should eventually be structured in such a way that it balances the allocated risks with benefits found elsewhere in the transaction. Secondly, the exclusion clauses and rules of interpretation affect the transaction cost of contracts. As the Courts have maintained a “hands-off” approach to exclusion clauses in commercial contexts, contracting parties must not only spend the time to watch out for exclusion clauses carefully, but they must also be ready to bargain over them.

In a hypothetical perfect market where all exclusion clauses are effective, the use of exclusion clauses in contracts should follow the same pattern as any other risk management device, such as negative pledge clauses or cross default clauses. The transactional cost of using exclusion clauses in commercial contexts however, is further complicated by Unfair Contract Terms Act and the growing use of standard form contracts. African Export-Import Bank illustrates the possibility for cat-and-mouse games between UCTA and the use of industry-wide standard-form contracts.

In African Export-Import Bank, the claimants, an Egyptian bank and two Nigerian banks syndicated a loan facility to the defendant, a Nigerian oil exploration and a production firm. When the defendant defaulted on the loan payments, the claimants accelerated the loan and began proceedings immediately. The defendant attempted to make a set-off claim. The claimants relied on a clause of their loan agreement which excluded the defendant’s right to set-off. In response, the defendants claimed that the exclusion clause was invalidated by section 3 of UCTA.

The Commercial Court ruled that this section did not apply to this case, as it only applies to written standard terms of business. In this case, the defendants were unable to adequately demonstrate that this exclusion clause was a standard term of business.

The commercial world is moving towards standardising contracts across more industries. If these contracts are drafted with the intention of being used, such as in the most common transactions, then each term must be reviewed carefully before it is included in the standard-form contract. The test for what the standard term of business is precisely what will incentivise industries in such a way. That is to say, drafters of standard-form contracts will primarily choose not to use exclusionary clauses and commercial firms will choose to use standard-form contracts that do not have exclusionary clauses. Then to avoid section 3 of UCTA, the bargaining party that would like an exclusion clause in the contract will have to induce further negotiation so that the resulting exclusion clause is a product of arms-length bargaining and not a standard term of business. The positive and expected result of this policy is that bargaining parties will be forced to take note of an exclusion clause. There is, however, a clear increase in transaction cost. It will almost become a requirement that parties take time out to discuss and negotiate each exclusion clause, ensuring that the term does not appear to be a standard term of business.

Section 3 of UCTA will increasingly be an issue as standards-form contracts and it will become increasingly common to facilitate transactions that are time-sensitive and frequent. Indeed, standard-form contracts are already common-place in most transactions involving product-sales. However, the use and nature of standard-form contracts is rapidly transforming. The next evolutionary step of standard-form contracts is smart-contracts; these have in fact already become more prevalent in the derivatives industry. In fact, they are arguably the technology behind the latest cryptocurrency, Ethereum, which is a rival of the block-chain based Bitcoin.

The appeal of smart-contracts may also be a point of concern regarding the law surrounding exclusion clauses. Smart contracts are contracts or assets that are programmed to be executed as soon as possible. If derivatives or cryptocurrencies are supported by a smart-contract platform, each transaction could amount to hundreds or thousands of “standard-form” contracts being executed simultaneously. Furthermore, it is difficult to imagine that smart-contracts would be programmed and designed without trying to exclude some form of liability. The nature of smart-contracts is such that these transactions will go through with little supervision. If an unexpected issue arises during the transaction and it produces economic loss, then there is potential liability for the parties to this automatic transaction, as well as the one who programmed their smart-contract.

Thus, as the terms of a smart-contract will inevitably become standard terms of business, it becomes difficult to reconcile smart-contracts and standard-form contracts with law and legislation which are designed to encourage arms-length bargaining and careful thought before implementing a contractual term. Although exclusion clauses are not common in the current implementations of smart-contracts, such as derivatives, repo financing, and cryptocurrency, the scope of smart-contracts will soon expand to include everyday transactions where exclusion clauses are common. One example is the potential for smart-contracts to be used in apartment rentals or Airbnb, where parties will try to exclude liability for losses such as property damage.

In conclusion then, the law of exclusion clauses must adapt to a world where standard-form contracts are becoming the norm in commercial contexts, and smart-contracts are becoming widely available. With recent developments in artificial intelligence and smart-contract technology, it will not be long before the tech industry decides to re-think a long-established industry by implementing smart contracts. The current state of the law, with its hands-off approach to exclusion clauses except where they are a standard term of business, favours careful examination of each exclusion clause and causes higher transaction costs across commercial industries. There must be reconciliation if exclusion clauses are to remain an important instrument of risk allocation and bargaining, as the remainder of the commercial world is, with no doubt, moving to lower transaction costs through digitising and standardising contracts.

Jospeh Lai currently serves as Policy Centre President of Law at King’s Think Tank.